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Barings was oldest merchant bank in London (founded in 1762). Financed the purchase of Louisiana by the USA from France in 1803 Had survived trouble in the end of the 19th century (panic of 1890) The Queens bank
Arbitraging
arbitrage: The practice of taking advantage (for profit-making purposes) of a price difference between two or more markets. The profit results from making simultaneous matching deals on both markets. Normal practice in BSS: Simultaneously buying and re-selling (in two different exchanges, Singapore and Japan) a quantity Q of futures contracts at a price-difference of p, resulting in profit =Q p. Because p0, Q (large quantity) in order to get a substantial profit . Leesons unauthorised practice: Speculation! Held on to the quantity for a certain period of time before re-selling.
Example of risk-free switching (by means of identifying and utilising small price differences). No risk if the contracts are not retained. The variation margin payable to the clearing house in Singapore (SIMEX) should be zero!
variation margin = The cash transfer that takes place after each trading day (and sometimes intraday) in most futures markets to mark long and short positions to the market.
The variation margins on the retained contracts were paid through the backoffice error account, which was infamously labeled 88888. Barings was unaware of Leesons speculations.
Leeson manipulated his books to show a profit on Baring's switching activity. Cross-trading : Matching the positions of two accounts when these positions belong to the same client.
Unauthorized!
Collapse - 2
Leesons positions were damaged. Thinking that he could recoup the losses, he started acquiring long positions on Nikkei 225 Index. He actually thought that he would be able to support the Nikkei 225 by himself. Initially, this increasingly risky strategy seemed to work because at the end of Jan. / beginning of Feb. there was a temporary high of the index. But soon the course downwards became dominant, breaking again the lower limit of 18.000 on 23d Feb. 1995. After that day, on which 65 million was lost, the end was inevitable. Leeson escaped from Singapore. Subsequently, his actions (and losses) so far were exposed (total losses generated = 827 million), to the detriment of the bank.
million
February 27, 1995 Barings' futures positions acquired via Leeson: US$ (million) Nikkei 225 index futures Japanese government bond futures
straddle options sold ("written") capital of Barings sum transferred to BSS from Barings London and Tokyo in order to cover margin obligations in Jan.-Feb. 1995
835
Growth of funding to BSS from within Barings. This funding was used by Leeson in order to cover margin payments. Senior Barings management continued to fund Leesons activities because they thought his positions were secure (hedged).
By Dec. 1994: Actual (hidden) result: 200 m losses (4.8 m in his first three months only). Reported result: 102 million profit (on which tax was paid and bonuses were distributed to employees). In early 1995, Leeson continued to trade aggressively. By falsifying records, he appeared to be making profits.
net positions in global derivatives trading were practically unknown to the central office
Management inadequacy
Example: Famous quote by Peter Baring, Chairman of Barings, in 1993, that indicates this inadequacy: The recovery in profitability has been amazing following the reorganization, leaving Barings to conclude that it was not actually terribly difficult to make money in the securities markets.